Why Big Tobacco Must Enter $1.7 Billion Pot Industry

Small-cap marijuana stocks have garnered significant interest on Seeking Alpha over the past few months. Since the industry is not fully established yet, there are no large-cap producers in the "pot industry." However, large-cap companies, like Philip Morris International (NYSE:PM), Altria (NYSE:MO), and Reynolds American (NYSE:RAI), can learn a thing or two from following the lead of these small-cap companies. Below, I explain why this is the case by first detailing the success of one such small-cap company and then explaining why it will translate into success for Big Tobacco.

NUVILEX ENTERS MARIJUANA FOLD AS BIOTECH PLAY

After establishing its "Medical Marijuana Sciences" subsidiary, Nuvilex (NVLX.PK) shares soared to an 80% gain pretty much instantly. Nuvilex's subsidiary is focused on using cannabinoids in biotechnology and pharmaceuticals. Nuvilex ultimately is a life sciences and biotech firm, so it comes equipped with experience in conducting clinical trials in this emerging healthcare space. In its Phase II trial for treating pancreatic cancer, Nuvilex found no adverse immunological events. The product approximately doubled the median survival time compared to the current gold standard. There was also a doubling in the number of survivors past 1 year compared to those using Gemzar. And it was this effective with only one-third of the normal chemotherapy dose used to treat other cancers. Nuvilex is now looking to release cannabinoid-based therapeutics that treat glioblastoma multiform, an aggressive form of brain cancer.

Nuvilex's decision to enter the high-growth medical marijuana market at the same time that it advances a cancer drug into late-stage clinical trials is particularly well-timed, because it legitimizes the pot industry. One of the biggest headwinds medical marijuana stocks face is the reality that many individuals still, inaccurately, see them as producers of pseudo-scientific treatments that will never outcompete biopharmaceuticals. As a biotech company with already promising clinical data, Nuvilex thus largely removes this kind of mindset in a way that positions the stock for strong returns.

With Nuvilex already catalyzing market returns by entering the market, wouldn't it be wise for Altria, Reynolds American, and PMI to do the same?

WEAK STOCK FUNDAMENTALS IN NEED OF CATALYST

By contrast, there has been a build up of investor fatigue in tobacco stocks. Since 28 November 2008 (around 5 years), Reynolds American, PMI, and Altria have risen by around 115% each. This outperformed the S&P 500 by 2,600 basis points. Reynolds American, PMI, and Altria now trade at 22.1x, 17.8x, and 16.7x past earnings, respectively. With the tobacco industry only forecasted for 1.5% annual earnings growth over the next 5 years at around a 7% discount rate, it suffices to say that these multiples are on the high side. Put differently, there isn't that much value left in tobacco, and the market has displayed signs of picking up on this through decelerating returns.

Assuming Altria, the marketer of Marlboro in the United States, grows at 7% over the next 5 years, 2017 EPS would come out to $3.15. At a generous multiple of 16.5x, the future stock price would come out to $52. Discounting backwards by 7% yields a present value of $37, which is only at a 10% premium to the prevailing price. The current ratio of 0.77x is also quite low and suggests the company may be stressed to explore costly growth opportunities. Investors are unlikely to jump onto this pricey stock with the economy entering "full recovery" mode.

PMI, the spin-off of Altria that targets only international markets, has problems of its own. Its PE multiple has gone up and up since 2009. At 1Q09, it hit a low of just under 10x. In 2010, the multiple rose to 14.9x. In 2011, it rose again to 15.6x. In 2012, it rose yet again to 16.5x. And it debuted the new year at 16.6x and has since risen to 17.8x. This compares to a historical 5-year average PE multiple of 15.5x. Thus, the stock faces downward pressure going forward.

Reynolds American is arguably in an even worse position. It trades at 22.1x, a premium to PMI and Altria, despite earnings erosion and lacking the leading brand. Free cash flow has gone absolutely nowhere since 2009--hovering around $1.5 billion. This translates to a weak 6.2% free cash flow yield, which is made worse by the double-digit EPS declines over the past 5 years.

Why Big Tobacco Must Make A Move

For decades now, Big Tobacco has become associated with stability. They are lionized for their friendliness towards shareholders and stable income streams. While smoking rates in the United States may fall and harm domestic returns for Altria and Reynolds American, few doubt that tobacco will be going away any time soon. Smokers will likely continue to smoke, and dividends will continue to roll out. PMI currently offers a 3.7% dividend yield; Altria offers a 5.1% dividend yield; and PMI leads the pack with a 5.4% dividend yield. Not bad for stocks that are, on average, 40% less volatile than the broader market.

However, on the other hand, Big Tobacco needs to start growing for two big reasons. First, dividends may very well be seen as an implicit concession by management that they don't know how to reinvest into high growth segments that will create more value. You either retain earnings and reinvest them into new businesses or your payout earnings to shareholders through repurchases or dividend distributions. Tech companies like to reinvest because there are plenty of growth opportunities while utilities and tobacco companies like to do payouts because opportunities are, well, few and far between. Second, as demonstrated above, the stocks currently have weak investors. In a macro recovery, investors are unlikely to jump into safe stocks over value and growth stocks. Therefore, management's focus should be on transitioning away from downside minimization (which Big Tobacco has historically been good at) to upside maximization.

What better way to excite the market than to make an entry into the marijuana market? If Nuvilex can achieve so much success from simply entering the market, as I demonstrated above, large-cap companies would be wise to do the same. Establishing a first-mover advantage is imperative, since the smoking market has shown strong loyalty. That is to say, making an inroad into a demographic/geographic now will secure recurring business later on.

Which Large-Cap Tobacco Producer Will Be The First To Sell Pot?

While I don't speculate Big Tobacco entering the pot industry any time soon, I believe they will in time. More and more states are loosening regulations against cannabis possession--just last year, NYC Mayor Bloomberg backed lowering the number of arrests. In 1996, California was the first state to legalize marijuana for medical purposes. Two years later, three other states--Oregon, Washington, and Arizona--followed suit. Now, 18 states plus Washington D.C., have legalized marijuana for medical purposes, and 6 of them did so since 2010. At the same time, more and more data is coming out about the positive effects of THC found within marijuana. In the end, something will give, and, at the time, the big players will inevitably make a move.

But which large-cap company will make the first move? This is obviously a very speculative question to answer, but I have my money on Reynolds American for several reasons. First, the company has been historically a bit behind the 8 ball when it comes to establishing inroads into the market. Second, it has the perception of being the "second best" among tobacco producers--management knows that it won't dethrone Altria and PMI's "Marlboro" brand any time soon. Third, management has already shown a strong willingness to experiment with product innovation, and this can perhaps be best seen by the introduction of e-cigarettes. And fourth, the company, in general, stands out for product diversity, and this is demonstrated by its successful foray into chewing tobacco.

Conclusion

In short, investors have significant opportunities within the marijuana space. The current Big Tobacco producers should reinvent themselves to have similar opportunities, because their current stock fundamentals are weak. The introduction of e-cigarettes by Reynolds American and others have already signaled to the market that Big Tobacco will not be resting on their laurels--they will expand into potential catalysts. In my view, the pot industry is one MAJOR catalyst that the Marlboros of the world will, and should, come to pursue. It is no surprise then that MSN Money has called it "the Green Rush"--likening it to the 19th century's "Gold Rush" that made countless millionaires. Fortunately, the market is just starting to pay attention.

Nuvilex, by successfully merging biotech into the "Green Rush," further demonstrates that the pot industry is for more than just the college student who wants to brag to his roommates about that "Rocky Mountain High" medical dispensary he owns shares in over in Colorado. It's a multi-billion dollar industry with huge growth potential that will bring in what many believe, again, to be the next great wave of millionaires. Therefore, Big Tobacco should enter the fold. And they should do so now.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Disclaimer: We seek business from all of the firms in our coverage, but research covered in this note is for subscribers and prospective clients, repeat or new, who may now or in the future have a position in any company mentioned herein that may be sold or increased. The distributor of this research report, Gould Partners, manages TakeoverAnalyst and is not a licensed investment adviser or broker dealer. Investors are cautioned to perform their own due diligence.

We only use your contact details to reply to your request for more information.We do not sell the personal contact data you submit to anyone else.

Thank you for your interest in Seeking Alpha PROWe look forward to contacting you shortly for a conversation.

Thank you for your interest in Seeking Alpha PRO

Our PRO subscription service was created for fund managers, and the cost of the product is
prohibitive for most individual investors.
If you are an investment professional with over $1M AUM and received this message
in error, click here and you will be contacted shortly.

Thank you for your interest in Seeking Alpha PROWe look forward to contacting you when we have an individual investor product ready!